APPENDIX

Notes for FOMC Meeting

September 16, 1980

Scott E. Pardee

Dollar exchange rates have moved narrowly against major currencies since the

August 12 FOMC meeting. Early in the period the dollar advanced by 1 to 2 percent

virtually across the board, as U.S. interest rates firmed. At the time, market participants

expected that interest rates abroad, and particularly in Germany, would be reduced in view of

slower economic growth if not recessions developing in most industrial countries. But those

interest rate expectations were not realized. Instead of cutting rates, the Bundesbank

increased rediscount quotas, simply placing on a more permanent basis liquidity that had

already been there. With the Bundesbank staying put, other EMS central banks also did not

move down on interest rates. The British authorities, with a huge bulge in the growth of

sterling M3, also remained firm on interest rates. Only the Bank of Japan cut its discount

rate--by 3/4 percentage point, but that was less than the market expected.

With the thrust of monetary policy abroad thus remaining restrictive, market

participants reviewed the latest data from the United States with caution. Indications that the

recession here was beginning to bottom out, that the monetary aggregates were growing

strongly once again, and that the producer price index was rising sharply as a result of the

jump in food prices all contributed to heightened concerns about the outlook for inflation in

the United States--at a time when other countries seem to be making clear progress in

reducing their rates of inflation. The exchange market remains skeptical over the tax cut

proposals that are coming forth from political candidates, for fear that the budget deficit will

be very difficult to contain. In addition, the exchange market has been alive with reports of

heavy OPEC diversification out of dollars and into other currencies. Much of this flow was

diverted into sterling and the Japanese yen--which has risen sharply during the period--but

substantial amounts have also moved into German marks and other continental currencies as

well. The upsurge in gold and silver prices is also largely attributed to demand from Middle

East interests, although again market participants believe that an intensification of

inflationary expectations in the United States is part of the cause.

The upshot is that even though interest rates in the United States continued to climb

in late August and early September, the dollar on balance slipped back in the exchange

market, in most cases to around the levels prevailing at the time of the last FOMC meeting.

The very fact that the dollar did not rise at a time of rising interest rates has been taken

bearishly. At least the selling pressure has not been heavy. We intervened on only three

occasions when the dollar came on offer, for a modest total of $33 million from balances.

Otherwise, the Desk continued to accumulate marks to repay Federal Reserve swap debt and

rebuild Treasury balances. Total purchases by the Desk amounted to $580 million. The

System's swap indebtedness was reduced by $320 million to $363 million. The Treasury's

short position in marks under the Carter notes was reduced by some $220 million, to $2.8

billion. We also found opportunities to acquire French francs, mainly through correspondent

transactions, and we reduced the System's swap debt to the Bank of France by $55 million to

$111 million.

FOMC MEETINGSEPTEMBER 16, 1980

REPORT ON OPENMARKET OPERATIONS

Reporting on open market operations, Mr. Sternlight

made the following statement.

A record bulge in monetary aggregates in the week of

August 6 cast a long shadow over the conduct of open market

operations and the behavior of financial markets since the last

meeting of the Committee. While some of the bulge washed out

in subsequent weeks, this did not proceed to the extent expected

initially, so that estimates of August growth worked higher over

the month. The reserve paths were drawn to accommodate a moderate

bulge in the early part of the period but events quickly out-ran

that element of accommodation.

As early as August 15, when we had just learned of the

August 6 bulge, it was estimated that demand for total reserves

would be about $125 million above path, so that adjustment

borrowing was expected to average around $200 million rather than

the $75 million initial level indicated at the August meeting.

As the period progressed, the expected excess of total reserves

above path worked higher, to about $380 million most recently.

Meantime, the path for nonborrowed reserves was reduced by $150

million relative to the total reserve path in view of the persisting

expected excess of total reserves, and largely reflecting these

developments it was anticipated by last Friday that adjustment

borrowing at the discount window would average about $600 million

for the five-week period ending tomorrow, including some $750

million in the current week. Because of a bulge in borrowing

this past Friday, the current week is more likely to turn out

around $1 billion or so and this could lift the 5-week average

to more like $650 million.

Along with the greater pressure on reserve positions,

the Federal funds rate also moved higher over the period, from

around 9 percent early in the interval to the area of 10 1/2 - 11

percent in the last few days. While permitting the rate to rise,

the Desk took care, particularly in light of Committee members'

comments during a conference call on August 22, to avoid actions

that might be read as aggressive moves to push rates higher--in

order to avoid or minimize the market overreactions that have

tended to follow Desk operations on several recent occasions.

The bulk of the Desk's outright transactions came quite

early in the pariod, on August 13, when the System bought about

$1.2 billion of coupon issues of various maturities--including

fair size at the longer end. It was fortuitous that we were

in a position, looking at reserve needs, to make this purchase

at a time when there was a sizable inventory available in the

market. Without the System's purchases, the interest rate

adjustments of the recent period might have been even more severe.

Later in the period the System sold $284 million of

bills to foreign accounts while $91 million of an agency issue

was redeemed without replacement. Temporary reserve transactions

included the daily arrangement of matched sale-purchase trans-

actions with foreign accounts and several instances of matched

sales to absorb reserves in the market. System repurchase

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agreements were arranged only once in the market, an action

that helped to spark a sharp price rally around Labor Day.

On several other occasions the Desk passed through some of

the foreign account repurchase orders to the market, but

market analysts tend to place more weight on the System's

own repurchase agreements even though the reserve effect is

similar.

Market rates rose across a broad spectrum during the

recent period. Major factors underlying the increase were the

sharp rise in money supply and resultant concern that the System

would foster greater restraint, the growing sense of emergent

economic recovery, signs of continuing inflation and indications

that demands on the credit markets from both the Government and

private sectors will be large in months ahead. After a sharp

slide in August, prices rallied for a few days around Labor

Day, apparently in response to what we considered some routine

repurchase agreements over the long weekend. The reaction

probably came about because it looked to the market as though

the System, up to then, had let rates push steadily higher

without resistance, and the System RP's, which happened to be

done when Federal funds moved up to 11 percent, were greeted

like a cavalry charge coming to the rescue of a damsel in

distress. Subsequently, the gains in the rally were approximately

retraced.

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Net over the period, bill rates rose roughly 150 to 190

basis points. Three- and six-month bills were auctioned yester-

day at about 10.64 and 10.88 percent, compared with 8.72 and

8.89 percent just before the last meeting. The six-month rate

is again in territory that causes the rate on related six-month

money market certificates to be quite costly to financial

institutions.

Intermediate-term coupon issues, up to about 5 years,

have risen about 120 to 185 basis points in yield over the period,

while long-term rates rose about 35 to 80 basis points. The

Treasury will sell 2-year notes on Thursday this week and 4-year

notes next Tuesday, possibly at rates approaching 12 percent.

At the moment, dealer inventories of over-1-year Treasury issues

are about $1 billion, rather moderate compared with about $3.6

billion at the time of the last Committee meeting which was in

the midst of the August refunding. Ordinarily the next Treasury

coupon issue would be some 15-year bonds in early October but

at the moment this is still a question until the Congress acts

to enlarge the leeway to sell bonds with coupons above 4 1/4

percent.

Finally, I should mention that we have recently trimmed

our list of officially reporting dealers by three names to 34.

The three names dropped are First Pennco, Nuveen, and Second

District. Desk trading with the latter two had already been

discontinued some months earlier, but they had remained for

a while on the reporting list. The reasons for dropping these

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firms from the reporting list varied: First Pennco is being

liquidated by its parent, the First Pennsylvania Bank; Nuveen

changed the character of its business from being a dealer or

market maker to being just an investment or trading account;

and Second District's volume of customer activity had dwindled

to a point that no longer met our standards for reporting dealers.

James L. Kichline

September 16, 1980

FOMC BRIEFING

Information available since the last meeting of the

Committee suggests a further improvement of activity in a number

of sectors of the economy. The staff has revised its forecast

of real GNP to show a somewhat smaller rate of decline in the

current quarter, and continues to expect the trough in activity

will be reached soon, if it hasn't already occurred.

Consumer outlays are one important area where activity

has picked up. Retail sales in August rose further, and the

previously reported June and July increases were revised up

appreciably. The August gain in sales was widespread, but not

nearly so large as in July, owing to a leveling in auto sales.

However, domestic auto sales in the first 10 days of September

advanced. The retail sales data became available after the

forecast was finalized, and they are considerably stronger

than those implicit in the forecast for the current quarter.

In housing markets the latest hard information on

activity is for July. In that month, home sales rose sharply

and housing starts edged up to a 1.3 million unit annual rate.

Scattered qualitative reports suggest that the rise of mortgage

rates has begun to damp the rebound in housing market activity,

with conventional mortgage commitment rates most recently

averaging a little above 13 percent--up more than 3/4 percentage

point since early August. The combination of somewhat higher

mortgage interest rates over the forecast horizon and com-

paratively weak growth of real disposable income is expected

to constrain the housing market recovery.

The labor market surveys for August also pointed

impressively to a rise in activity. Nonfarm employment increased

about 200,000, with half of that occurring in manufacturing--

the first monthly gain since February. Moreover, the average

length of the workweek in manufacturing rose hour. The unemploy-

ment rate edged down 0.2 percentage point to 7.6 percent.

The gains in employment and hours worked were

associated with a rise in industrial production in August,

the first since January. The index will be released this

morning and shows a gain of percent, while revised informa-

tion indicates smaller drops in output in both June and July

than had been published earlier. Gains in output last month

were fairly widespread, with notable increases in the production

of durable home goods and construction products--areas that

had been depressed sharply during the spring. The rise in the

overall index was limited by the 12 percent drop in auto

assemblies, a temporary factor reportedly accounted for by

parts shortages for some models.

Running counter to the string of stronger business

news is the information on business fixed investment. Shipments

of capital goods and construction spending in July remained

weak, and developments in orders and contracts suggest continued

weakness in future months. Confirming evidence of the weak

outlook became available with the Commerce Survey of anticipated

plant and equipment spending which showed an increase of only

8-3/4 percentin nominal terms for 1980, all of which occurred

in the first half of the year. The staff forecast of business

fixed investment was not altered significantly, and it continues

to portray declines in real outlays over the projection period.

Activity in the near term is also held down in the

forecast by the projected liquidation of inventories. Inventory-

sales ratios remain high, especially in manufacturing, even with

the recent increases in sales. We have continued to assume that

businesses will strive to obtain a leaner inventory posture

than now exists, but admittedly forecasting inventory behavior

is a chancy affair.

On the price front, the changes in the forecast this

month have been small. The effects of adverse weather on

food prices have continued to mount, and we added a bit more

to expected inflation in that sector. Prices overall are

projected to rise 10 to 10 percent in 1980 and about 1 per-

centage point less next year.

In sum, the general contour of the staff's forecast

remains the same as projected last month. Real GNP is expected

to show a small decline in the current quarter, be about

unchanged in the fourth quarter, and recover sluggishly next

year. The recent stronger business news we interpret as a

partial snapback from the severe drop in activity during the

second quarter, particularly evident in the auto, housing,

and durable home goods sectors. Those are the sectors that

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apparently bore the brunt of the credit restraints during the

spring. The basis for a sustained, strong expansion of economic

activity does not appear to be in place now or on the immediate

horizon, given high rates of inflation and restraining monetary

and discretionary fiscal policies.

FOMC BriefingS. H. AxilrodSept. 16, 1980

The unusual burst of money growth in August is apparently

being followed by a very modest expansion in September, but the rapid

August growth was sufficient to make it likely that expansion for the

third quarter (on a quarterly average basis) will be at a 9.8 percent

annual rate for M-1A, a 12.3 percent rate for M-1B, and a 14.9 percent

rate for M-2--all higher than the Committee had anticipated for that

period, though M-2 apparently will be only slightly higher. With the

August burst, M-1A and M-1B are now well within the Committee's longer-

run target ranges for the year 1980, while M-2 is just above its longer-run

range. Given the desirability of the Committee's not running over its

longer-run monetary targets for this year if a credible anti-inflationary

stance is to be sustained in face of stronger upward price pressures

than had been expected and slippage in the Federal budget, the question

naturally arises as to the practicability, in view of various economic

lags, of limiting money growth sufficiently in the three and a half

months between now and year-end to hit the longer-run targets.

This would probably be very difficult for M-2, and neither of

the alternatives presented to the Committee in the blue book would bring

M-2 back into target range. The yield on a significant and growing

portion of the non-transactions assets in M-2 can be adjusted by institu-

tions to changes in market rates, and so long as suitable investment

outlets are available to the institutions, they can be expected to

continue actively bidding for funds through instruments such as small-

denomination time deposits even while restraint on reserve availability

may be pushing up market rates. Thus, we may well see relatively strong

M-2 growth over the next three months--though slower than in the summer--

under either alternative A or alternative B unless the economy in the

fourth quarter turns out to be much weaker than expected and the flow

of income and savings is thereby greatly reduced.

With M-2 quite likely to run high, it would seem to be even more

urgent to keep growth in M-1A and M-1B within bounds. While that seems

feasible at this point, I would not take much heart from the apparent

weakness in M-1A and M-1B in September. At present levels of interest

rates, that weakness will probably give way to considerable strength before

the year is out, assuming that our projection of 11 percent in nominal

GNP growth in the fourth quarter is near the mark. How strongly the

Committee might wish to resist such a strengthening depends in part on

interpretation of second and third quarter developments with respect to

the narrow aggregates.

There is some question about whether the third quarter resurgence

in M-1 growth should or should not be viewed as an offset to the second

quarter weakness. Arithmetically, taking the two quarters together, M-1A

grew at about a 3 percent annual rate and M-1B at a 5 percent rate,

roughly paralleling expansion in nominal GNP at about a 3 percent annual

rate. From that simple viewpoint, it would be tempting to say that the

third quarter is best viewed as an offset to the second. But there is

more to it than that.

There was a sharp drop of short-term interest rates after the

first quarter. Given this drop in rates, and the GNP that we saw, a much

more rapid growth in money than developed would have been expected on

the basis of historical experience. The growth we didn't get represents

the so-called demand drift. All of this drift occurred in the second

quarter, when the actual level of money turned out to be a further 3-1/2

percentage points below the level predicted by our model. At the time,

we thought his might mainly represent not a permanent demand shift,

but a temporary downward blip related to, for example, use of cash to

repay debts in consequence of the credit control programs. In the latter

case, an at least partially offsetting greater than usual strength in

money growth might have been expected in the third quarter. But strong

as the third quarter is, the rapid growth in narrow money does not appear

to represent, so far as our equations tell us, any significant compensa-

tion for the second quarter drift. Rather, given the lagged upward

effect on money demanded from the second quarter drop in interest rates,

the growth was about what the model would have predicted if the public

had indeed decided to get along permanently with a lower stock of money

and not make up for the second quarter shortfall.

Thus, the rapid growth of money in the third quarter does not

appear to represent, to any significant extent, efforts by the public to

make up for the second quarter weakness. Rather, we now do seem to be

getting the rapid growth that might have been anticipated in any event

and that appears consistent with the pull of inflationary pressures.

And it would then seem probable that strong demands for money are likely

to persist into the fourth quarter, particularly if nominal GNP is given

an added fillip from improvement of the economy in real terms. Thus,

even if September money growth is weak, the odds strongly favor rapid

expansion on balance over the remainder of the year.

The following implications might be drawn for the Committee's

policy decision as between alternatives A and B, or variants thereof.

First, under either alternative some further upward pressure on

interest rates seems likely between now and year-end, with such pressures

larger and sooner under B.

Second, if the 3-1/2 percentage point drop in money supply level

below model expectations in the second quarter can be taken as the drift

for the year, as seems to be the case in view of recent experience, then

it might be taken as an argument for preferring the more restrictive

alternative B--with its implied 4 percent M-1A growth for the year--to

alternative A. When the FOMC reaffirmed its 1980 monetary targets in July

our estimate of drift at that time was on the order of 2-3/4 percentage

points. Now we seem to have 3/4 percentage point more drift--or technically

speaking 3/4 of a point less money would be needed to finance the same GNP.

In that case if the 4-3/4 percentage midpoint of a 3-1/2 to 6 percent range

for 1980 was satisfactory in July, then 4 percent as implied by alternative B

should be satisfactory now. This conclusion might be buttressed by the

probability that M-1B would probably run high within its range and M-2

above its range even under the constraints of alternative B.

Third, and finally, it should be pointed out that, the relatively

low growth in narrow money under alternative B between now and year-end--

only 3-1/4 percent at an annual rate growth--runs a high risk, in my

judgment, of quickly eroding the base for an economic recovery--largely,

of course, because a recovery now appears to be occurring before there has

been much, if any progress in containing inflation. The greater monetary

expansion under alternative A than alternative B would run less risk of

stymieing the recovery--though it is certainly not without risk in that

respect, but it would run a little more risk of building in an inflationary

momentum that would make the problem of monetary control even more

difficult next year.